Think carefully before lending to family, friend

By Benjamin Salisbury

Financial loans to family or friends are common but can cause friction. Close relationships can blur the boundaries between a loan and a favour. So, what do you do if you want to make a loan to a friend, but want him to treat it as a formal business agreement? What are the best ways to get the loan repaid?

Before you agree to the loan
There are many good reasons to lend, such as allowing someone to pay off a bill that charges high levels of interest, or to repair a relative's car they need in order to work.

loan-to-family

Equally, there are examples of bad reasons to make a loan, such as
lending people money to buy the latest phone when they already have a perfectly good one, or to fund an expensive holiday. Before deciding
whether to lend, you should ask yourself a few questions, such as:

  • Can you afford not to get the money back? This is a worst-case scenario,
    but is not unusual with loans to friends and family.

  • Can the borrower afford to repay the loan? Consider their employment status and their other financial commitments.

  • Is the borrower responsible? Do they regularly spend more than they earn?

  • Why does the borrower need the money? "Things like, ‘to pay household bills' or ‘to pay off existing creditors', these two reasons already show that
    the individual is not as astute with money as you would like them to be, lessening your chance of getting your money back," Steven Little said in an emailed response to questions. Little is a senior consultant from Debt Collect UK, which provides debt recovery solutions for businesses.

    "If your friend or family member is using the loan to pay off debts, then loaning additional money will most likely add to their problem rather than resolving the underlying problems," added Andrew Johnson, money expert at the government-backed Money Advice Service, in an emailed response to questions.

"Look into all the options available before you lend them the money," Johnson said. "They might be able to cut back on spending to help them find the money they need. You can direct them to [Money Advice Service's] cutback calculator to work out how much they could save each month."

What legal rights do you have?
"None, unless you get a legally-binding contract drafted up by a solicitor that is signed by both parties and witnessed," said Little. "We would strongly recommend that you do this before lending any money to a friend or family member."

Draw up a contract that plainly states the terms of the loan. This should include how much you will lend, over what period, at what rate and the monthly repayment amount. "This [contract] would be accepted in court in the event of a dispute," said Johnson.

What conditions should you attach to the loan?
Charging interest on a loan is a good idea because it makes the transaction seem more business-like. The interest charge only has to be minimal and can be below the market rate so you are still offering favourable terms. If you are using your own money that could be earning interest, you may want to charge that amount of interest on the loan.

You can include provisions in the contract to allow amendments in case there is a change in circumstances, such as the borrower losing their income.

If you are lending a substantial amount, attach a condition that you will receive some collateral in lieu of being repaid. You should also include provision to take action, such as selling off the collateral, if repayments stop.

With this in a contract, both parties are aware of the conditions before the loan is made and a record exists in case there is a dispute.

Once an agreement you are both happy with is in place, transfer the money or write out a cheque, rather than pay cash, which would leave no record of the transaction. For the same reason, arrange for the borrower to set up a monthly direct debit or a standing order to your bank so repayments are guaranteed to be on time.

Getting paid back
If the borrower is struggling to repay the loan, or loses their job, you could offer them a "payment holiday", giving them a period to sort out their situation before continuing with the repayments.

But if there is a total breakdown of relations, you may have to go to court. If the loan is for less than £5,000 you may be able to use the small claims court; if it is for more than £5,000, you will need to get independent legal advice.

However, "it should only be used as a last resort, negotiation not litigation with these types of cases is key," said Little.

See related: Owe a friend some money? What you need to know about mobile money transfers, What to consider before adding authorised user

Updated: 1 March 2016